Should Time Warner Investors Fear Netflix?

(Source Warner Bros.)

“We had another very successful year in 2013,” said Time Warner (NYSE:TWX) Chair and Chief Executive Officer Jeff Bewkes proclaimed in the media company’s fourth-quarter and full-year earnings release. Yes, Time Warner — owner of Time magazine, the Home Box Office premium cable network, CNN, and Warner Bros. studios — beat Wall Street expectations for fourth-quarter profit and made the biggest increase to its stock-buyback fund in seven years. Investors, who bid shares 48.56 percent in all of 2013 but pushed shares down 10.5 percent this year to date, reacted to the earnings release and the stock buyback with modest optimism. Shares advanced as much as 0.34 percent — reaching 62.40 — in pre-market trading Wednesday morning.

Time Warner operates three segments: Networks, Film and TV Entertainment, and Publishing, and the company’s earnings beat largely came from the box office success of two films: The Hobbit: The Desolation of Smaug and Gravity. But strength in the company’s Turner Broadcasting business — which includes, CNN, TBS, Cartoon Network, Adult Swim, as well as its premium cable channel HBO – also enabled Time Warner to post its fifth consecutive year of double digit growth. Both the Networks and Film and TV Entertainment units contributed significantly to profitability, posting strong viewing numbers and garnering numerous awards in the past year.

TBS was ranked as ad-supported cable’s number one network in primetime television for adults ages 18 through 49; Adult Swim recorded its most-watched year in history and remained the number network on ad-supported cable among adults ages 18 through 34 for the ninth straight year; HBO received the most Emmy Awards of any network, tied for the most Golden Globe Awards, and notched its biggest gain in domestic subscribers in 17 years; and, Warner Bros. had its best year ever, with its films earning “an industry leading 21 Academy Award nominations — including best picture nominations for Gravity and Her.” Plus, Warner Bros. television shows — The Big Bang Theory, The Voice, and The Following — posted strong numbers as well.

Excluding certain charges, Time Warner earned $1.17 per share in the fourth-quarter, a few cents over the $1.15 predicted by analysts on Wall Street. Meanwhile, revenue also surpassed expectations, rising 5 percent to $8.6 billion. Yet, even though profit beat expectations, higher costs and several write-downs hurt growth at HBO, causing overall profit to come in 12 percent lower than in the year-ago quarter.

There are weaknesses in Time Warner’s entertainment armor. HBO is locked in a tight battle with Netflix (NASDAQ:NFLX). The Internet streaming service ended 2013 on a high note; its rapid rate of subscriber growth continued into the fourth-quarter, with 2.3 million new American households signing up for its streaming service. Alongside subscriber growth, revenue rose 24 percent year-over-year to $1.18 billion in the fourth-quarter, while profit rose to $48.4 million, or 79 cents per share — an increase from the $7.9 million or 13 cents per share Netflix earned in the year-ago quarter.

Netflix is facing questions from analysts who wonder how long the company’s growth can continue, but HBO faced a much harsher reality in the final months of the year. Even though revenue jumped 6 percent to $1.3 billion on the back of an 8 percent growth in subscribers, the gains were partially offset by a 9 percent decline in content revenue. More concerning was the 12 percent increase in programming costs, which caused HBO’s profits to fall 4 percent to $414 million. The increase in programming costs was the result of higher original programming expenses and the consolidation of HBO Asia and HBO Nordic.

Still, pay-television providers like Verizon Communications (NYSE:VZ) and Comcast (NASDAQ:CMCSA) are paying more for Time Warner’s content, which ranges from HBO’s Girls to professional basketball games on TNT. Subscription revenue at Turner Broadcasting, which includes TNT and CNN, climbed 6 percent compared to HBO’s 8 percent. The fact that pay-television providers are paying more for content suggests strong ratings for Time Warner. But analysts want to know just how good the ratings are. Bernstein Research analyst Todd Juenger said in a research note obtained by Reuters that investors will be expecting an update on advertising demand — a metric closely related to ratings –when Time Warner executives hold a conference call later on Wednesday. “Ratings matter a lot. Time Warner had the most problematic fourth-quarter ratings among any of our coverage companies,” Juenger said.

Subscription growth at HBO and Turner Broadcasting reflects Bewkes’ decision to focus the company’s growth strategy on its cable division, which accounts for more than 70 percent of its operating income. In furthering this plan, he spun off the cable-provider Time Warner Cable (NYSE:TWC) soon after taking over as chief executive in 2008.

Bewkes plans to also divest the publishing unit Time Inc., which is currently the company’s worst performing division, by the end of June. However, merger discussions with Meredith Corp. (NYSE:MDP), owner of women’s publications like Ladies’ Home Journal broke down in March. In the past quarter, Time Inc. reported revenue of $966 million, which was relatively flat with the third-quarter, but reflected a 6 percent decline in subscription revenue and a 2 percent increase in advertising revenue. Once the magazine business is spun off, Time Warner will focus solely on film and television entertainment, particularly the cable networks that continue drive company growth. For the fourth-quarter, revenue rose 3 percent to $2.5 billion in the Turner division thanks to higher subscription and advertising revenue — although profit did fall three percent to $879 million as the result of higher programing costs. Meanwhile, fourth-quarter revenue rose 7 percent to $4 billion at Warner Bros., mainly because of stronger theatrical returns. Profit increased 4 percent to $576 million.

For 2014, Time Warner expects adjusted per-share income to rise in the low-double digits, excluding Time Inc. Comparatively, analysts have predicted a 13 percent increase. Alongside fourth-quarter earnings, the company increased its quarterly dividend 10 percent to 31.75 cents and the board of directors approved a buyback of $5 million.

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